Futures are financial contracts giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. Futures are also called futures contracts.
There are four main types of futures traders in the futures market, creating the liquid futures trading environment that we see today. No matter what a trader chooses to do in futures trading, they will inevitably fall into one or more of these types. The four types of futures traders are really classified based on the purpose of their trades rather than the actual trading strategy itself, as the same futures strategy can be applied for various purposes. They are:
- Hedgers: Hedgers do with futures contracts what futures contracts were initially designed to do when they were first developed along the rivers of Chicago, which is to hedge against price risk. A trader is a hedger when they go short on futures contracts while owning the underlying asset or other futures contracts of the same or related underlying in order to protect their existing positions against price fluctuations.
- Speculators: Speculators form the backbone of the futures trading market we see today. They provide liquidity and activity in the futures trading market through their day trading or swing trading strategies, buying and selling futures contracts outright in order to speculate on a strong directional move. This is also the most dangerous way of trading futures, as the price of the underlying asset could just as easily come around and put your position in a loss deep enough for a margin call.
- Arbitrageurs: Arbitrageurs are futures traders that are in the market in order to spot price anomalies between futures contracts and their underlying assets in order to reap a risk free return. Arbitrage is another huge source of volume and liquidity in the market as it typically takes an extremely big fund and big trading volume in order to return a worthwhile profit in arbitrage. Arbitrage is such a competitive area right now that super computers with powerful programs to spot such opportunities are set to perform such arbitrage automatically.
- Spreaders: Spreaders are futures traders that specialize in trading futures contracts in combination with other futures contracts or underlying assets in order to reduce risk and to extend profitability. Such complex futures positions are known as "Futures Spreads" or "Futures Strategies." This is a very professional and highly specialized field that has only recently been made known to the general public and makes use of the difference in price and rate of change in price of different offsetting futures contracts in order to create futures positions that move within certain limits and have a much higher chance of profit with a lot lower commissions.
Examples of futures at work
The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth and certain financial instruments are also part of today's commodity markets. Two types of futures traders’ response to these assets are:
- Hedgers do not usually seek a profit by trading commodities, but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying physical commodity.
- Speculators are usually not interested in taking possession of the underlying assets. They essentially place bets on the future prices of certain commodities. Thus, if they disagree with the consensus that wheat prices are going to fall, they might buy a futures contract. If their prediction is right and wheat prices increase, they could make money by selling the futures contract (which is now worth a lot more) before it expires (this prevents them from having to take delivery of the wheat as well). Speculators are often blamed for big price swings, but they also provide liquidity to the futures market.
Futures contracts are standardized, meaning that they specify the underlying commodity's quality, quantity, and delivery so that the prices mean the same thing to everyone in the market. For example, each kind of crude oil (light sweet crude, for example) must meet the same quality specifications so that light sweet crude from one producer is no different from another and the buyer of light sweet crude futures knows exactly what they are getting.
Futures trading is a zero-sum game; that is, if somebody makes a million dollars, somebody else loses a million dollars. Because futures contracts can be purchased on margin, meaning that the investor can buy a contract with a partial loan from his or her broker, futures traders have an incredible amount of leverage with which to trade thousands or millions of dollars’ worth of contracts with very little of their own money.
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